Retiring in Australia and Spending Dividends Only

Big ERN has a new blogpost about the safe rate of withdrawal in retirement. He takes on people who say that you can avoid the problem of selling assets when their price is low by investing in high-yielding assets and only spending the dividends or interest. The highest yielding portfolio he looks at has yielded an average of 3.6% p.a. and it looks like it ends up selling capital in the great recession of 2008-9.

Australian shares have a high dividend yield. They yielded 4.25% last year not counting franking credits. If as ERN assumes you withdraw 4% of the portfolio in the first year and then increase that withdrawal by the rate of inflation can you avoid selling shares? The short answer is: yes!

These are my assumptions: We invest in the ASX 200 index without fees (could be replicated by a portfolio of 20 stocks maybe?) and we don't pay taxes (it's a superannuation account in pension phase) and so we get the grossed up value of the dividends (Labor plans to eliminate these refunds if they win the next election). I start with $900k in shares and $100k in cash and get the Reserve Bank interest rate as interest on the cash. Then all dividends and interest are paid into the cash account.

My first simulation assumes we retire at the end of March 2000. This was not a good time to retire as it was just before the dotcom/tech crash. But the ASX200 index started in April 2000 and so data before then is not very reliable. This is what happens:

Starting in 2000 we would now have almost $1.7 million in shares and $900k in cash. If we'd reinvested some of the dividends we probably would have been even better off.

To stress test the model, I also do a simulation that assumes you retire at the end of December 2007 just before the great recession/global financial crisis. This is what happens then:

Obviously, it's not as good and you would have $970k now, more than 10 years later. In real terms the value of the portfolio will have fallen substantially. But so far, you won't have had to sell a single share with $138k in cash currently. Over the last couple of decades this strategy has worked well.

This suggests that investing in stocks in countries with traditionally high dividend yields like Australia and only spending the dividends is a viable investment strategy. If you need to pay taxes on withdrawals as in the case of a U.S. 401k account then you will need to start with more money invested to fund the same level of spending.

Interesting Paper from GMO on Bursting Stock Market Bubbles and Anti-Bubbles

Here is the paper. Yes, they think that we were in a bubble in 2017 and much of 2018 and the last quarter of 2018 was the beginning of the bursting of the bubble. The problem with the CAPE measure of valuation they use is that it is so backward-looking. If profits are growing fast, CAPE will be high because it uses the average profits of the last 10 years. It has the built-in assumption that profits growth is very strongly mean-reverting.

The Average Hedge Fund No Longer Produces Alpha

I regressed the excess (above risk free rate) monthly returns of the HFRI fund-weighted hedge fund index on the excess returns of the MSCI All Country World Index (gross returns):

Back at the turn of the century, the hedge fund index had alpha between 5 and 10%. But it collapsed going into the financial crisis and in the most recent 5 year period alpha is -0.17% p.a. Beta is 0.34. The r-squared between the MSCI and HFRI excess returns is 0.86, which is high. So, you might as well invest 34% of your money in global stocks and the rest in cash to replicate the index. Interestingly, a linear trend line rather than an exponential trend line fits the index:

So, it doesn't make sense to invest in hedge funds recently unless you can select an above average fund.

David Svensen Lecture at Yale

Svensen is the manager of Yale's endowment. He also gives occasional lectures at Yale.

My investment strategy is strongly influenced by endowment investors like Svensen.

Portfolio Charts

Portfolio Charts is a really interesting website where you can do simulations of safe and permanent withdrawal rates and many other things for a range of investment portfolios. These include predefined portfolios and you can also build your own portfolio using a range of ETFs. Here for example is Tony Robbins' version of Ray Dalio's All Weather portfolio:

The orange line gives the withdrawal rate which means that you wouldn't have run out of money if you retired in any year since 1970 and retired for the length of time on the x-axis. The green line is the withdrawal rate that means that you will have at least as much money as you started with in real terms. It's interesting how these go in opposite directions as the length of retirement increases. If you retired for 30 years the permanent withdrawal rate is 3.8%. This portfolio had an average real return of 5.5%. The best performing portfolio in terms of withdrawal rates is the site creator's own "Golden Butterfly" which has 40% stocks, 40% bonds, and 20% gold:

This portfolio had a real return of 6.5%.

An interesting point is that safe and permanent withdrawal rates vary a lot by country. The site allows you to choose the US, UK, Canada, and Germany as home countries. The linked article also includes Australia, but unfortunately the site itself doesn't allow you to do analysis for Australia. A big caveat is, of course, that all this depends on historical returns. If bonds, for example, don't do as well going forward as they did from 1980 till recently then, withdrawal rates are going to be lower. Choice of alternative investments is also limited to gold, a commodities ETF, and a REIT ETF.

Will Listed Investment Companies Restructure if Labor Eliminates Refundability of Franking Credits?

As you probably know if you live in Australia, Labor plans to abolish the refundability of franking credits - the tax credits attached to dividends for company tax already paid. This will affect taxpayers with low marginal tax rates including self managed superfunds that are paying out a pension, which is tax free if they have less than AUD 1.6 million in assets for that member. This could significantly cut the retirement income of self-funded retirees who have a lot of Australian shares. OTOH, this was the policy prior to 2000 and most other offsets, like foreign tax credits, aren't refundable either.

I already plan to have relatively small amounts of Australian shares when I start an SMSF - this makes sense as I have lots of investments outside super and so it makes sense to put the least tax efficient investments like managed futures into super.

Listed investment companies (LICs) are closed-end funds that pay tax on their earnings and then distribute franked dividends to shareholders. I own shares in several of these like Platinum Capital, Cadence Capital, Hearts and Minds, and Tribeca Global Resources. Both Geoff Wilson and Cadence Capital's Karl Siegling have suggested that they will reorganize their funds if this happens. There are a couple of ways this could happen. One I had thought about, is to delist and turn the fund into a unlisted managed fund (mutual fund). For funds that trade at a premium to NAV, like several of Wilson's funds, this would cause investors to lose a lot of money as now their holdings would only be worth the NAV. For funds trading at a discount to NAV it could be attractive, as shareholders would gain wealth (but see below). To the extent that the funds receive franked dividends from companies, they would still have to distribute franking credits, but capital gains would no longer create franking credits.

Another option I didn't know about, is that they could instead convert to a listed investment trust like an ETF that doesn't pay taxes. This solves the problem of wealth destruction for funds trading at a premium to NAV.

But the article I linked says that this would result in realization of the portfolio for tax purposes. This could be a huge tax bill for companies like Argo that do little trading. The funds will need to pay out a massive special dividend to distribute the associated franking credit. According to Argo's website they will need to pay 72 cents in tax for liquidating the portfolio. That means they would have to pay a $1.68 cash dividend and so actually sell 23% of the portfolio to pay the dividend out. Some other funds have undistributed franking credits and so would also need to sell shares to generate the cash for such a dividend. They will need to do this soon, as there will probably be an election next May. So, I am a bit skeptical that many will.

Target Portfoilo Performance November 2018

The target portfolio gained 0.22% in AUD terms. Offsetting losses in Ausrtalian shares, gold, and unhedged foreign shares there were gains in particular in managed futures and buyout PE.

Put Writing Strategy

ERN recently posted again about his put writing strategy. Despite the market falls in October he ended up for the month. This seems to be down to luck that after his contracts went into the money (which means a loss if you write options) around 12th October, they then recovered substantially before the expiry date. I was curious about the performance of such a strategy in the long term. You can now buy an ETF that implements a similar strategy. It differs a little from ERN's strategy. In particular, the ETF sells options each month, rather than 3 times a week. It tries to match the performance of the CBOE S&P 500 put writing index. The index goes back to 1986! In the following I analyze the performance of the strategy since January 2007. Looking at the chart of the index, it seems to track the fluctuations in the stock market quite closely over the last 10 years:

Most of the time there is lower volatility and then there are occasional spikes. When I regress monthly returns on the monthly returns of the S&P 500 total return index (i.e. including dividends) I get a beta of 0.64 and annualized alpha of 0.9%.* The R-squared is 0.74. After transaction costs that alpha will likely disappear. This is looking a lot like investing 64% of your money in an S&P 500 ETF and the rest in cash with occasional volatility spikes added in.

Of course, this might not be much like the return profile that ERN is getting as his performance in October shows.

 * This isn't the classic CAPM regression where you deduct the risk free rate first, but that won't make much difference here.

Private Equity and Venture Capital Indices

I commented that I didn't have a good proxy for private equity and venture capital. So, I went and found one and came up with these indices from DSC Quantitative Group. What they do is regress a quarterly indices of private equity buyout and venture capital funds from Thomson Reuters on various sector indices of listed stocks. They update these weights each time Thomson Reuters produce a new number. Because they are using listed stock indices as proxies they can then produce a daily index for private equity. The fit of the proxy to the underlying index is not too bad. This is for venture capital:

 The biggest deviation is during the financial crisis - unlisted private equity fell by more than the proxy index had predicted. When we compare the proxy to the NASDAQ total return index, it looks superficially like a leveraged version of the index:

When I regress it on monthly NASDAQ total return index data for 2008 to 2018, I get a beta of 1.15 and annual alpha of 6%. This suggests that venture capitalists add value by rotating the sectors that they invest in over time and it's not just about leverage:

Alpha is given by the intercept of 0.4% per month. I didn't do the proper CAPM regression where you are supposed to deduct risk free returns from the two returns series first. Given the volatility here and low risk free rates since 2008, I doubt it would make much difference.

Interestingly, the Cambridge VC index estimates much lower returns, close to the returns of the NASDAQ index itself.

You could do all this analysis for the buyout private equity index too. You'd want to regress that on the S&P 500 total return index instead.

Australian Corporation Tax

The Australian government has lowered the rate of corporation tax on small businesses and planned to lower the rate on larger businesses too. The latter was blocked by the Senate. The main reason put forward for reducing the tax seems to be increasing international competitiveness, though this is less important for small businesses that mainly don't have international investment in them. Today, the news is that the government wants to bring forward by several years the reduction to 25% for small businesses as a pre-election vote winner. Labor, by contrast, opposes this cut (they withdrew their policy to repeal the previous cut) and wants to raise all sorts of taxes on investment.

As an Australian investor in public companies I didn't used to care too much how high the corporation tax was. This is because when a company pays tax and then pays a dividend, Australian investors get a "franking" credit for the tax paid by the company, so there is no double taxation. Foreign investors usually can't use these credits, hence the argument to partly level the playing field  by bringing down the rate of the tax. If a company doesn't distribute profits and the share price increases and I sell my shares and pay capital gains tax, then there is double taxation. But the long-term capital gains tax is only half the normal income tax rate and so this isn't too bad (Labor want to reduce this discount too). Additionally, the price paid for listed shares takes into account that profits are taxed, which helps mitigate the impact of the tax on the rate of return that investors receive. Australian investors, though, are willing to pay more for Australian shares than international investors are, given their differential tax treatment.

Actually, I like getting franking credits, because after I deduct investment costs like margin interest they reduce the tax on my salary.

But as I think about setting up a private company, I increasingly like the idea of lowering the corporation tax. Profits that are re-invested in the business, rather than paid out as dividends, are greater if the tax rate is lower. Of course, this applies to listed companies too, and cutting the tax rate should raise the price of shares in a one time move. The more that we have existing investments rather than are buying new investments the more we should like increases in share prices... On the other hand, ot all the extra profits from lowering the tax rate will actually be realized. Market equilibrium should mean that after the rate of return increases, firms invest more, lowering the pre-tax rate of return. This mechanism is much like how stock market investors will buy shares raising the price and reducing the expected rate of return again. But lower taxes on investment are economically more efficient.

Internal Rate of Return and Private Equity

Private equity funds like to report the returns on their investment using the internal rate of return metric. The IRR is the discount rate which results in the net present value of the stream of cashflows from the investment being zero. This article points out that it is only the true compound rate of return if you can reinvest the payouts that you receive over time at the same rate of return (r.o.r.). This is correct. But it then goes on to say that IRR is meaningless if you can't reinvest the distributions at the same r.o.r. I don't think that is right. If the IRR is higher than the r.o.r. that you can invest the distributions at, then your r.o.r. from investing in the private equity investment and reinvesting your distributions is greater than the r.o.r. you'll receive by just investing in your alternative investment (and vice versa). Your actual r.o.r. won't be as high as the IRR but the IRR is still useful for making decisions. The main issue is that you need to deduct the funds fees to get the true IRR. Often they will report that they made a $1 million investment and sold for $2 million and give the IRR without deducting fees. Probably as a back of the envelope calculation you could deduct 1/4 of the stated IRR in these cases and then compare to your alternative r.o.r.

So, for example, in Aura's latest report to investors they reported IRR's to date on two investments of 59.5% and 29.2%. So, yes, these are very good. Of course, those are the investments whose carrying values they are marking up. They report a 21.3% IRR on an investment they are exiting. But then there are others that are just breaking even.

Mean Reversion vs. Momentum Strategies

This is an interesting interview. About half way through he makes a deep point that if you use an oscillator type indicator and sell it when it is overbought and buy when it is oversold that is a mean reversion strategy. If you do the opposite - buying when overbought and selling when oversold then it is a momentum strategy. And those are really the only two options for directional trading using such indicators. Well, he also says that 95% of assets follow a random walk and can't be predicted. My system basically tells me when to switch between momentum and mean reversion. For me there isn't really something that is not predictable though when volatility is low predictability goes down.

Backtesting and Hedged Portfolios

So, I backtested for all of 2017 using the latest model rules. The model makes money for the year, but there are several losing months, and the model underperforms the market. I could quite easily predict which months would be more profitable and which were more likely to be money losing by looking at their volatility. So, that idea works out of sample.

 

The graph shows the NASDAQ 100 index (close) for 2017 and the model return. The interesting thing is that a hedged portfolio of the market and the model, tracks the market quite closely. The hedging strategy would invest 75% of net worth in the QQQ ETF and use 25% of net worth to trade NQ futures with 3 times leverage according to the model. So it is 1.5 times leveraged with 50% of the total exposure long and 50% traded. Of course, you wouldn't really want all your portfolio into the the QQQ ETF. At least I wouldn't. But this is a step towards seeing what a realistic strategy with investment and trading would look like. Now if we look at 2018:

The hedged portfolio tracks the model, which vastly outperformed the market, closely instead now. It seems that you can get the best of both worlds with this strategy.

Volatility and Return

The graph shows the average true range (ATR) divided by the closing NQ futures price for all 14 day periods in 2018 so far and the average daily NDX model return over the same period. The correlation is very strong. The model tends to make lots of money when the market is volatile and potentially lose money when the markets are not volatile. This is why the model would have lost money in early 2017 for example and probably why the NASDAQ index produces better results than the S&P 500. Clearly, noise dominates signal when volatility is low. However, the correlation between recent volatility and future returns is quite weak. So, this isn't yet a useful tool for deciding when to trade and when not to trade on a daily or weekly basis. But if you were losing money for a while and volatility was low it would make sense to get out of that market and trade something else until volatility appeared to return.

I'm still holding the strategic long contract. It's up around $4k at the moment. I did a couple of tactical trades netting $215 and $980.

The Kelly Criterion

There is a lot of incorrect information on the web about applying the Kelly criterion in the stockmarket. It is very different to applying it in a card game where you either win or lose a fixed amount. In that context the Kelly criterion tells you how much to bet on each gamble. But whether you are doing short-term trading or long-term investing that is not the case in the financial markets where there are continuous payoffs. In this paper, Ed Thorp lays out the Kelly criterion for investing in financial markets. It results in a rule of how much leverage to use when investing in a portfolio. That portfolio could be a buy and hold portfolio of stocks, or it could be a high turnover futures trading account. To determine how much of total net worth to allocate to a particular asset class or strategy is a different calculation. I think you should maximize the Sharpe ratio for your total portfolio. Where to set the stop loss in trading is a similar calculation - you want to use stop loss rules that maximize the Sharpe ratio for the strategy. I don't think Kelly tells you how much to risk on each trade in the way it can tell you how much to bet on each gamble.

The Kelly criterion isn't a practical rule in the real world as it requires you to continuously change the size of your position as you win or lose money. The suggested leverage for my trading model – this may be exaggerated because of too short a sample of returns and volatility – is greater than that allowed by the futures exchange. This amount of leverage would immediately blow up in the real world and result in huge amounts of commission and bid-ask spread payments...

Flipped Back to Short

The model was long NQ for one day and lost a little (it remained short ES, surprisingly). Now it has flipped back to short. Given yesterday's post, I'm still thinking this is a limited correction. Here is a possible interpretation based on Elliott Wave Theory:

We are now in wave C of 4. Based on Elliott Wave Theory that wave should stop before price falls below the maximum point of Wave 1, as shown on the graph. I find Elliott Wave very useful in understanding the different things that might happen, but I don't think it is an exact fit to what the market does, especially on very long and very short time scales. Over the time scale shown on this chart, it is particularly useful. On the other hand, Eliott Wave is notorious for continually morphing and following what the market does, rather than predicting it.

Of course, my model has nothing to do with Elliott Wave Theory it is just nice to have some other approach that does not conflict with the model or confirms it.

If you look closely you'll see I'm short from 6911.5 and up quite nicely, but I was up $500 when long yesterday evening too and that reversed...

P.S.
The downside didn't last long! Market turned around in the morning US time and went up, eventually reaching above the top of the triangle in the chart above. At one point I was up USD 1500, but unfortunately I didn't take profits as I was sticking to what the model said to do. Now I am considering doubling my position during the Australian daytime - the US overnight and then closing half in the US morning. If I had done that yesterday I would have ended up on the day. I am going to backtest the strategy of course. 10 years back when I previously was trading futures, I did look at "overnight trading" as a strategy, and now it has come up again.

Model has now flipped back to long. S&P model was short till today, and now has also gone long.

These 13F Tracking ETF's Have Horrible Performance

13F is a form lodged quarterly by US based investment funds. A 13F following strategy takes the stock picks from top hedge funds as revealed by their 13F forms. Two ETF's that follow this strategy are ALFA and GURU. But both have horrible performance with negative alpha of of -5% and -7%, which is rather ironic. Does this strategy no longer work?

Types of Trading

There are lots of types of trading. Some of the important strategies are the following:

1. Market-making: A market maker profits from the bid-ask spread in the market, selling at the ask and buying at the bid. This is very apparent in options markets where there is usually a big bid-ask spread. They can hedge their "delta" risk by buying or shorting the underlying security - for example for futures options they can buy and sell futures contracts. For individual stocks - if they are trading a diversified basket they can again hedge using futures contracts (or ETFs). It is possible for individual investors to make markets in small and illiquid stocks - ie. selling at the ask and buying at the bid, but it is a very slow process waiting for people to trade with you.

2. Arbitrage: This exploits pricing anomalies, for example between futures contracts and ETFs for the same underlying index. Short one and buy the other. Occasionally, there are big arbitrage opportunities such as the famous Palm case.

3. Mean reversion: These are generalizations of arbitrage. For example, buying closed end funds (listed investment company in Australian) when they are selling below net asset value and shorting them when they are above. I've done this quite a lot with Platinum Capital (PMC.AX - just selling when above NAV - but actually there is a CFD you could use to short the stock). This is arbitrage between the value of the portfolio and the price of the fund. Statistical arbitrage is a market-neutral mean reversion trade where stocks that have risen in value are shorted and those that have fallen are bought. It was pioneered by Ed Thorp.

4. Selling option premium: This relies on the time decay of options. Most options expire worthless and risk aversion means that buyers should pay in net to reduce their risk. So option sellers should on average win. Again, delta risk could be hedged away in theory. The simplest case is covered calls where the trader buys a stock and sell a call - though actual delta hedging is a lot more complex than that.

5. Information trading: Here the trader knows information that they think will move the security. For example, recently I bought shares in IPE because Mercantile did. I assumed correctly that their analysis must have shown that the underlying portfolio was worth more than the stock price. This is a kind of mean reversion/arbitrage of course and is could also be seen as investing. Even after the company released news of the sale of Threatmetrix to Elsevier, the price didn't immediately move to the new higher NAV.

6. News trading: Here the information is not yet known but a trade is placed to take advantage of it. For example, if I know that Apple Computer will release their earnings but I don't have a hypothesis of which way it will move the stock, I could buy both calls and put options in the hope that a big move will make one increase by more than the other decreases. This seems pretty close to gambling - option prices should take into account the size of likely moves, so you are gambling that the move will be bigger than the market thinks.

7. Trend following/momentum trading: This is what most people think of as trading. The trader tries to take advantage of market momentum. This is the approach taken by many managed futures funds. Much online trading advice is based on this.

8. Hedging: These traders trade to hedge their investment or business positions. For example, an airline buying oil futures contracts to guarantee their future price of oil or an option buyer hedging an investment portfolio. The latter might also sell options to fund the hedging puts.

What have I missed? This paper has an interesting discussion of types of traders.

Safe Withdrawal Rates

Interesting simulations of safe withdrawal rates over longer time horizons by ERN. The lowest withdrawal rate simulated is 3% p.a. Ed Thorp states that 2% is actually the safe capital preserving withdrawal rate. Our current spending is about 2.75% of estimated total net worth including the inherited money. But I expect our spending to continue to increase faster than inflation for a long time to come.

Optimal Portfolios

I have been doing some experimentation with designing optimal portfolios, something which I last looked at in 2011. I have the monthy rates of return on various asset classes going back to 1996. These include international shares (MSCI World Index, gross) both hedged into Australian Dollars and not. Australian shares (ASX 200 accumulation), Managed Futures (a mix of Man AHL and Winton), direct real estate (a particular US fund as a proxy), hedge funds (HFRI index), the bond market (again I'm using a fund as a proxy), Australian Dollar cash, and gold in Australian dollars. You can use the solver in Excel to find the allocation that monthly rebalanced gives the highest Sharpe Ratio. This optimal portfolio varies over time but generally it doesn't like hedge funds and allocates about 10-20% to gold, and 20-40% to managed futures. Because future performance won't necessarily be the same as past performance (particularly a worry for managed futures) and because managed futures, in particular, are not tax effective – they pay most income out subject to marginal tax rates – I wouldn't allocate according to a particular optimization. A target portfolio gets near the optimal performance while being more diversified and a bit more tax effective:

This graph shows the performance of various assets and a "target portfolio":

Here the target portfolio is 25% international shares (half hedged into Australian dollar and half not), 25% Australian shares, 25% managed futures, and then 5% in each of real estate, bonds, cash, gold, and hedge funds. Then the whole thing is geared up a bit with borrowing. It performs pretty nicely over various historical periods.

Here we have a close up of performance since the financial crisis:

I've managed to match the performance of the Australian index but have lagged behind the MSCI World Index. It matches the performance of the MSCI but has a smoother path. The next graph shows ten year rolling returns:

Here we see that such a portfolio clearly dominates in the long-run over regular stock indices or my own performance, which has not been good over a ten year period recently. The graph also shows how the performance of the Australian stock market has declined. It had very high ten year  returns prior to the crisis, but now has lower returns than international shares over the last ten years.

I have been moving in the direction of the optimal portfolio by diversifying out of Australian shares and buying managed futures, but it has been too slow so far. In the last few months I have been buying $A10k of managed futures each month. I also allocated more to international investments when I reinvested my CFS superannuation fund in their wholesale funds.